Wednesday, 8 January 2014

Will the MPC raise UK interest rates in 2014?

Chris Giles of the FT thinks they will. His reason is straightforward: economic growth will continue to outstrip productivity growth, implying unemployment will fall below the MPC’s 7% threshold, and the MPC will worry that inflation will start rising.

While I try an avoid making forecasts (see my first answer to the FT questionnaire here), I would agree that strong growth in 2014 is more than possible. The savings ratio could continue to fall, net trade could pick up and non-residential investment may begin to recover. It would be bad news if this was accompanied by continuing near zero productivity growth, but as we do not know why UK productivity growth has stalled, we cannot rule this out.

Yet if interest rates did rise as a result, it would be extraordinary. To see why, just compare the UK with the US. US GDP began growing strongly at the end of 2009. So the UK is a full three years behind. Yet the US still has interest rates at their zero lower bound, four years after their recovery began, and has only just begun to scale back increases in its quantitative easing programme. (The MPC stopped increasing their programme some time ago.) So if we followed the US, there would be no question of raising rates this year.

The UK has been unusual in the past because of inflation. While US inflation has been at or below target for the past year and a half, it has been above target in the UK for 4 years. Yet the UK inflation rate is now down to 2.1%, despite the recovery in output. So it increasingly looks like high UK inflation in the past was down to a number of temporary factors, which the MPC rightly ignored. This is consistent with other measures of UK inflation, which have been lower throughout.

Now of course if inflation really does look like taking off in 2014, the MPC will raise rates. But what would ‘taking off’ mean precisely. As the MPC focuses on inflation two or so years down the line, I think it would have to mean a sudden tightening in the labour market. Given that unemployment is currently around 7.4%, and averaged 5.25% between 2000 and 2008, and earnings growth is currently running at 0.9% in nominal terms (!), we seem to have a long way to go before anyone could argue the labour market is about to initiate a wage price spiral.

Think of it another way. UK GDP is currently between 15% and 20% below where it would have been if it had followed past trends and there had been no recession. Past trends involved average growth rates of at least 2%. With that historically unprecedented gap, if two years of GDP growth one or two per cent above that past average meant monetary policy had to be tightened, it would mean accepting that something catastrophic and irredeemable had happened to the UK economy. That is why a rate rise this year would be extraordinary.


Now you might say a small increase in UK short term interest rates would still mean that monetary policy was easy, but just a little less so, and so a modest rate rise would be no big deal. The Resolution Foundation would strongly disagree. In a recent report they looked at the impact that various different scenarios for interest rates would have on households. The following chart indicates the key point.


The left hand panel gives the proportion of households paying over 25% of their disposable income in debt repayments (light pink), and over 50% (dark pink). The key point is this. The 2011 proportions are not very different from the average over the previous two decades, despite interest rates being much lower. In other words, we have not seen a wave of defaults and repossessions following the recession because the MPC cut interest rates to the bone. If interest rates rise but real wages do not (because productivity growth continues to stall), then that wave may happen after all. (See the right hand panel.)

As a result, even a small increase in interest rates is likely to have a large impact on at least some parts of the UK economy. The Bank is well aware of this (pdf, HT Pieria), so members of the MPC should not take this action lightly. As I have argued before, given the risks and uncertainties associated with the economy’s current position, it makes much more sense to take risks with inflation than to risk stalling the recovery. But I also thought that in 2011, when GDP growth was flat, and a third of the MPC disagreed, so nothing is for sure.

We can at least be thankful that interest rate decisions are not made by the so called ‘Shadow MPC’, a group set up by the Institute of Economic Affairs. They have been voting since February 2013 to raise interest rates! How can you vote for higher rates before a recovery starts, when it is obvious that there is large scale involuntary unemployment and underemployment? Well back in the 1940s Michal Kalecki had a theory, but then he was a Polish immigrant!

20 comments:

  1. The modelling resource economyuk is showing that, even if interest rates stay unchanged, unemployment will start to increase in the second half of this year to plateau at 8% before slowly falling. The model also predicts that even a modest increase of 1% in interest rate this year will have the undesirable effect of causing unemployment to rise to 8.5% and to stay at this level for some time (Page 1 at www.economyuk.co.uk). It would seem that the original decision to reduce interest rates so quickly to their current very low level was, to say the least, somewhat misguided.

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  2. The economics of it are irrelevant.
    We wouldn't be seeing any rate increase before the end of the year anyway.
    By then we'll be in pre-election mode. Like the US Fed, the MPC won't be making any changes in the run up to the election. This is little understood in the UK (unlike in the US) because this is (I think) the first time there could be any change in the run up to an election by the independent MPC.

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  3. A bit off topic, buy why adjust demand by adjusting interest rates at all? Adjusting interest rates influences demand for just one lot of goods: investment goods. Why not adjust demand by changing the price of some other set of goods, say cars, restaurant meals and electricity?

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    Replies
    1. How would you suggest one changes the price of another set of goods?
      Adjusting demand by setting interest rates is done (as you say) by affecting the crucial investment goods. This method has the advantage of not creating a lot of distortion in the economy.
      Adjusting demand by forcibly (through government decree?) decreasing the price of for example cars and/or electricity would lead to a much decreased or even negative profits for companies in those industries. This creates massive distortions and gives incentives for workers and capital to move on to the other parts of the economy that still lack this regulation.
      The resulting uncertainty -who knows which industry is going to be hit next?- would certainly drive much of the capital in the country (domestic and foreign) abroad as well.
      But maybe you were suggesting another method for lowering these other prices?

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    2. Ralph, why do you keep repeating this point and keep ignoring everybody who points out it's not true? If interest rates go up, my mortgage goes up and my demand for consumption goods goes down. If demand for investment goods goes up, wages and employment will be affected which will also affect demand for consumption goods.

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    3. Louis,

      If debtors pay more interest, that’s more money for creditors / savers, so to that extent there isn't much effect on consumer demand. However, assuming debtors have a higher propensity to spend, there’d be a finite effect of the sort you refer to.

      However, there’s some distortion there: debtors and creditors are affected differently. Also the above “propensity” phenomenon is temporary. E.g. given an interest rate cut, debtors will up their spending, but that cannot go on for ever. I.e. they’ll up their spending till they’ve incurred the maximum amount of debt they can cope with.

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  4. Hi Hugo,

    I wasn’t seriously suggesting adjusting car or electricity prices: I was just illustrating an illogical element in interest rate adjustments, namely that they adjust demand for a relatively small selection of goods, that is, investment goods (capital equipment, etc).I.e. I don’t agree with your claim that boosting demand for investment goods is particularly distortion free.

    Escaping a recession purely by cutting interest rates would be justified if some omniscient government could prove that the recession was cause just by an unwarranted drop in investment spending. But plant capacity utilisation in the US is at a historically fairly low level at the moment, so perhaps employers’ reluctance to invest is justified. Plus the recession was caused to a significant extent by reduced spending by those underwater mortgagors (i.e. a drop in consumer current rather than capital spending was part of the problem).

    All in all, it’s difficult to know what mix of interest rate cuts and fiscal stimulus its best. Certainly I wouldn’t like to see interest rate adjustments as the ONLY weapon used. Simon suggested a mix of the two in his 6th Jan post. Plus I’m happy with the MMT idea that the distinction between monetary and fiscal policy be abandoned and we just create new monetary base and spend it (and/or cut taxes) in a recession. And taking that further, Warren Mosler suggests a permanent zero interest rate. I'd be happy to give that a go, but presumably you wouldn't.

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    Replies
    1. Apologies for the slow reply.

      Now I understand better what you're saying. I think there are good reasons why lower interest rates are better than fiscal stimulus, ceteris paribus. For one thing, investments raise the gdp growth several years into the future and thus help solidify confidence that an economic recovery will continue.

      Another reason to focus on monetary stimulus has to do with the idea of the intertemporal consumer used in new-keynesian models. According to this model, a lot of people will not immediately spend what they gain from a tax cut but rather smooth consumption out over a long period of time. Obviously this isn't very relevant in the current crisis where multipliers are large but (I think) we're discussing general principles here and a lot of the time, the marginal propensity to consume will be low.

      You are correct that I don't like the thought of a permanent zero interest rate (although rates may have to stay at zero for years in the current situation).

      One last point: Our positions probably appear more different than they actually are. Like you I think a combination of monetary and fiscal stimulus right now, not least because combining two policy instruments with uncertain effects makes it a lot easier to hit the target.

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    2. I don’t agree that investments resulting from interest rate cuts necessarily “raise the gdp growth..”: at least they won’t do so if the interest rate cut is ARTIFICIAL. That is, GDP is maximised where the interest rate is the free market rate (unless someone can demonstrate market failure). Plus the Fed has just published some research which indicates that the relationship between interest and investment is tenuous. See:

      http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

      Re consumption smoothing, obviously that takes place to some extent, but the empirical evidence is that when households receive tax rebates or other windfalls, they spend a significant proportion within a year or so. See:

      http://onlinelibrary.wiley.com/doi/10.1111/j.1745-6606.1984.tb00322.x/abstract
      http://www.nber.org/digest/mar09/w14753.html
      http://www.kellogg.northwestern.edu/faculty/parker/htm/research/johnsonparkersouleles2005.pdf
      http://finance.wharton.upenn.edu/~rlwctr/papers/0801.pdf
      http://www.eea-esem.com/files/papers/eea-esem/2012/1382/chz1a.pdf
      http://www.newyorkfed.org/research/current_issues/ci7-11/ci7-11.html

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    3. The sources you cite to contradict consumption smoothing are a bit odd (perhaps you didn't think I would actually look at them?). They actually support my argument more than yours.

      The NBER study confirms that the marginal propensity to consume has been high in the current crisis, something that all reasonable commentators know is true (and which I mentioned in my previous comment).

      Both Rucker and Steindel show that the marginal propensity to consume is somewhere around a third. This is precisely what most proponents of the idea of consumption smoothing say and, indeed, it's what Friedman himself believed.

      The studies by Agarwal, Liu and Souleles; Campbell and Hercowitz confirm that consumers do spend some of their tax rebates immediately. They then go on to explore why that is the case, coming to the usual conclusion of liquidity constraints as well as "impatient households".

      All of this is consistent with what modern keynesians believe and suggests that monetary policy is a far more effective tool for stabilization most of the time.

      Finally, the paper by Sharpe and Suarez is very interesting but it is only a working paper. Also, as the authors themselves write; "Simultaneity bias from unobservable shifts in investment demand" is a possible explanation for why the stimulating effect of the interest rate does not show up in the statistics.

      See this paper by Simon Wren-Lewis and others:
      http://www.economics.ox.ac.uk/department-of-economics-discussion-paper-series/when-is-monetary-policy-all-we-need

      Delete
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    ReplyDelete
  6. «Almost everyone agrees that UK house prices are currently much too high, and (partly thanks to you know who) getting higher.»

    Property price obsessed marginal voters obviously are pretty numerous, and they alway agree that house prices should go up a lot more. Do you ever look at the Telegraph and Mail? "you know who" have to win an election against the UKIP in many South East seats in 2015, at any cost to someone else.

    There are plenty of middle aged and older, usually female, middle class voters in the South East (and London) who feel entitled to tax-free capital gains every year, easily cashable with remortgaging (at very low interest rates) without actually selling the property. These are swing voters and decide elections, because the whole North always votes Labour and the upper classes in the South East always vote Conservative.

    How big is the effect? According to the BBC:

    http://www.bbc.co.uk/news/business-19288208
    «In 2001, the average price of a house was £121,769 and the average salary was £16,557, according to the National Housing Federation. A decade on, the typical price of a property is 94% higher at £236,518, while average wages are up 29% to £21,330»

    That's a (usually) tax-free capital gain of around £12,000 per year, and 240k houses are (in the South East) 2-up, 2-down terrace houses that are usually owned by people on median wages, who see their after tax income boosted by at least 50-70% by capital gains.

    A typical example that only ended badly because the nominal valuation of the house as the collateral to the mortgage did not grow fast enough:

    http://www.dailymail.co.uk/money/mortgageshome/article-2105240/Stuck-rent-trap-How-middle-class-family-kept-remortgaging-home-pay-bills-longer-afford-repayments.html
    «Certainly, we overstretched ourselves when we bought our lovely period home for £419,000 in 2002. But with mortgage companies practically throwing loans at us in a rising property market, we slept soundly at night, smug in the knowledge the house was making us money. [ ... ]
    We were lulled into a false sense of security about our wealth. Whenever we overspent we just remortgaged without comprehending the consequences of taking yet more equity out of the property.
    In our defence, we weren’t spending the money on ebxpensive designer clothes, luxurious holidays or flash cars. Much of it was going on school fees and upkeep of the house.»

    Also, governments of the past 30 years have used the magic of ever rising house prices and remortgages to boost the lifestyle of middle class marginal voters:

    http://www.opendemocracy.net/ourkingdom/oliver-huitson/thatcher-black-gold-or-red-bricks

    «Another of Thatcher’s magic potions was ‘home equity withdrawal’ or remortgaging – drawing down the equity in the borrowers home for (mainly) consumption purposes – new cars, holidays, and so forth.
    Under the two Prime Ministers that preceded her, James Callaghan and Ted Heath, home equity withdrawal as a percentage of GDP growth was around 36% for both.
    Under Thatcher, this exploded to over £250bn across her premiership – a staggering 104% of GDP growth. [ ... ]
    [ ... ] But Blair did his homework and let loose – as did Thatcher – a wave of cheap credit, financial deregulation, house price inflation and an equity withdrawal-led consumption boom.
    Withdrawals under Blair’s leadership totalled around £365bn, that’s a full 103% of GDP growth over the same period,»

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  7. Also *nominal valuations of collateral* are pretty much the core of the situation in another way: in both the USA and the UK the commanding heights of the financial system have been nationalized after stupendous accounting losses due to falling nominal valuations of collateral.

    There have been no protests from the political right because the commanding heights of the financial system have not been nationalized in the interests of the lazy, parasitic proles, but in the interests of the superproductive management class that runs them :-), whose jobs and compensation and bonus pools have been largely protected.

    Plus if financial system were to go bust, so would a whole lot of collective investment vehicles like pension funds, because they have invested large chunks of their assets in a merrily pro-cyclical way, as financial company stocks etc. have gotten an ever greater weighting in their investment portfolios.

    Banks in particular essentially cannot go bankrupt in a cashflow sense, only in a purely accounting sense, as central banks have guaranteed that they will always supply unlimited cash to both illiquid or insolvent banks, against good, bad or no collateral, at incredibly low and highly profitable interest rates. Just as Bagehot recommended :-).

    As to the accounting sense, banks have really very thin bases of (theoretical) capital, and the rest is a precarious balance between vast masses of lending and the value of the collateral posted against that lending.

    For the more metaphysical "assets" like nth degree derivatives that are opaquely and thinly traded various governments have joyously "relaxed" (nice sounding word) the accounting rules by allowing financial companies to mark the collaterals to fantasy, so that no matter how dubious the lending looks, the nominal valuation of the related collateral, in accounting terms, ensures that the accounts of the banks seem fine.

    It is a bit more difficult to ensure that for loans against houses (for mortgages) and stocks (for margin loans) the nominal valuations of those collaterals match the stupendous value of the borrowing against them, as those nominal valuations are public records.

    Because if nominal valuations of collateral fall even slightly, the thin base of capital gets immediately torched, and then it becomes pretty hard to pretend that the financial system and pension funds are not bankrupt.

    Therefore vast supplies of new borrowing (much cash, low interest) are essential to keeping the lid on a lot of pretty nasty situations. Besides politicians, especially Conservative ones, when they retire they don't earn extra money by working down the pit or in factories; they feel entitled to directorships in City financial companies, and this makes a big difference between their willingness to throw hundreds of billions at mines and manufacturers or at banks and stockbrokers.

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  8. I find it interesting that some people should contemplate increasing interest rates at a time when inflation has fallen despite a lack of higher interest rates. Will inflation rise just because it has fallen? It's not as certain as gravity.

    One result of the 2008 crisis was a 20% devaluation of GBP against the USD. This pushed import prices up, and increased inflation as the UK economy is a net importer of goods. Now the FX rate has stabilised, inflation has fallen, despite the economy reviving. This growth isn’t causing price increases, perhaps because so much production now takes place outside of the UK economy, in China, Germany and elsewhere.

    Even house price inflation is feeling the effects of globalisation, at least in London. Foreign money, less affected than domestic money by UK rates, has created a London price bubble that is skewing National house inflation figures. Perhaps Vince Cable's idea of a mansion tax isn't so silly after all.

    More and more it seems to me that local economic policy will have less and less effect on the UK economy. Meanwhile, the real problems of needing to radically restructure and broaden the base of the UK economy are in danger of being ignored. One of the few projects to actually look to the future, HS2, is in danger of being killed off by nimbyism.

    Such a shame the opinion formers seem to have their backs turned to the future in order to better contemplate the past. Whatever happened to vision?

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  9. «a 20% devaluation of GBP against the USD. This pushed import prices up, and increased inflation as the UK economy is a net importer of goods. Now the FX rate has stabilised, inflation has fallen, despite the economy reviving. This growth isn’t causing price increases, perhaps because so much production now takes place outside of the UK economy, in China, Germany and elsewhere.»

    Ahhhhh but you are not seeing one of the biggest elements of the picture, that the UK ceased being a net exporter of oil in 2007-2008 and as a result that has been a boom in the imports of oil, my usual graph here:

    http://mazamascience.com/OilExport/output_en/Exports_BP_2013_oil_mtoe_GB_MZM_NONE_auto__.png

    The politics of the last 30 years are largely described in that graph, as
    http://mazamascience.com/OilExport/output_en/Exports_BP_2013_oil_mtoe_GB_MZM_NONE_auto__.png

    The politics of the last 30 years are largely described in that graph, as Tony Blair wrote lucidly in 1987 (ten year before becoming prime minister):

    http://www.lrb.co.uk/v09/n19/tony-blair/diary
    «The economy has been growing under the impetus of a consumer boom that would have made Lord Barber blush. Bank lending has been growing at an annual rate of around 20 per cent (excluding borrowing to fund house purchases); credit-card debt has been increasing at a phenomenal rate; and these have combined to bring a retail-sales boom – which shows up dramatically in an increase in imported consumer goods.
    Previously such a boom and growth in imports would have produced a balance-of-payments deficit, a plunging currency and an immediate reining-back on spending, with lower rates of growth. Instead, oil has earned foreign exchange and also produces remittance payments from overseas investments bought with oil money.
    The situation is neither stable nor healthy in the long term: but in the short term it allows the living standards of the majority to rise rapidly, even though the industrial base, the ultimate foundation of a successful economy, is still only achieving the levels of output of 1979.
    The fact that we have failed to use oil to build a productive and modern industry for the future is something historians will deplore.»

    «the opinion formers seem to have their backs turned to the future in order to better contemplate the past. Whatever happened to vision?»

    The opinion formers cannot ignore that South East property owning voters want more tax free effort free capital gains every year of 50-70% of their post-tax income, and could not care about less about vision; they aspire to the good life.

    As a the Chancellor pointed out as to inheritance tax, property capital gains are a core aspirational value of voters:

    http://www.telegraph.co.uk/finance/personalfinance/consumertips/tax/9861439/David-Cameron-abandons-inheritance-tax-pledge.html
    « He criticised the tax as hitting the “aspirations of ordinary people” and said that in a “Conservative Britain” people would “not be punished for working hard and saving hard”.
    Mr Osborne said: “When inheritance tax was first introduced it was designed to hit the very rich … Instead, thanks to Gordon Brown, this unfair tax falls increasingly on the aspirations of ordinary people. [ ... ] People who feel the most basic human instinct of all: they aspire to a better life for their children and their grandchildren.”»

    Many swing voters don't care about "vision"; they care about asset prices going up and taxes on assets going down.

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  10. You're right, the current Tory leadership do seem more concerned with staying in power than they are with leading the country with a vision of a brighter future for everyone. Perhaps that's why they ignore sensible macroeconomic policies in favour of following tabloid opinion?

    You are also correct in saying voters are interested in feeling better off. Asset price inflation is fools gold though; if the unit of currency were houses it doesn't matter what the exchange rate to GBP was - if each voter on average only ever owns 1 house, he never gets any richer. Of course, there is the inflating debt away argument, but really that just transfers wealth to the finance sector and those countries who make things; the homeowner still owns just one home.

    If the unit of currency is "Full Time Jobs" (FTJ) then the policies of the past have clearly impoverished the same voter since it now takes 2 or 3 FTJ to buy a house when in the 1950s only 1 FTJ was needed for the same purchase.

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  11. «Asset price inflation is fools gold though; if the unit of currency were houses it doesn't matter what the exchange rate to GBP was - if each voter on average only ever owns 1 house, he never gets any richer.»

    Oh please, this is ridiculous and misleading!

    Each voter does not on average own 1 house, that's a strange premise given that the numbers are well known: 60-70% of voters own *at least* one house, and those who own it outside the South East don't matter much, because the easy money is in the South East. Home owners that live in the North East for example not only have not benefited that much from government-guaranteed asset prices bubbles, if they move, as many do, to the South East to work they have to pay massively inflated house prices or rent to the tory voters there that the Thatcher and Blair government enriched to get their votes.

    Also the assumption is ridiculous in the extreme because it makes a big difference in a big government-guaranteed house price bubble *when* one gets in on the ladder.
    In particular the South East incumbents who bought council houses in the 1980s with the first wave of Right-To-Buy, and their heirs, quite a lot of them altogether, are in a very different position from those who bought in 2006.

    Also, the "if each voter on average only ever owns 1 house, he never gets any richer" is ludicrously misleading because house owners do not own houses of the same value: when prices double, those who bought a 100,000 house make a tax-free income of 100,000, but those who could afford to buy a 400,000 house make a tax-free capital gains income of 400,000; and the distance between the ladder's steps widens, so that the owner of a house that went up in price from 100,000 to 200,000 will need to pay 100,000 instead of 50,000 extra or upsize to a house that from from 150,000 to 300,000.

    Also the vital role of remortgaging, as I tried to point out above, means that with low interest rate remortgages owners can cash in their capital gains tax-free without formally selling the house, simply because its valuation as collateral has gone up.

    A lot of people cashed in with remortgages; a lot of people did get those extra 12,000 a year of tax-free income on their house.

    «have clearly impoverished the same voter since it now takes 2 or 3 FTJ to buy a house when in the 1950s only 1 FTJ was needed for the same purchase.»

    That's also ridiculous, because that matters only to people who upsize, either from not owning a house, or from one to two house, or from smaller to a bigger house. Those who downside or remortage (downsizing in place) get a huge wad of cash to reward them for being swing voters in the South East.

    And never mind that a large chunk of the professional middle classes, whose political influence is huge, have seen their income grow if not at the same pace as house prices, much faster than everybody else. Doctors, dentists, solicitors, managers in the South East have seen the GBP value of their FTJs go up quite substantially, over the same period.

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  12. «Therefore vast supplies of new borrowing (much cash, low interest) are essential to keeping the lid on a lot of pretty nasty situations.»
    «Much of it was going on school fees and upkeep of the house.»

    The latter quote I should have continue with:

    «Much of it was going on school fees and upkeep of the house. By the beginning of 2008 we had remortgaged three times, taking out a staggering £500,000 loan on a house that wasn’t worth much more. Our interest-only mortgage payments had soared to nearly £3,000 a month.»

    A £500,000 mortgage secured by a house that became worth rather less and is *interest-only* and they remortgage! Voters in the South East really *love the good times*! :-)

    There is one juicy little detail that came up during a Parliamentary committee enquiry, which shows that MainlyMacro's argument that interest rate will stay low as long as possible is also motivated by solvency issue:

    http://www.publications.parliament.uk/pa/cm201314/cmselect/cmtreasy/uc458/uc45801.htm
    «Q28 Mark Garnier: One problem that I have advanced on a number of occasions-and a paradox that I can’t quite see a solution to and I would be grateful if you could point in some direction on this-is the fact that we have a colossally high level of household debt that is getting on for £1.5 trillion, of which about £1.2 trillion is on mortgages and of which about 40% of that is only on interest-only mortgages with no discernible way of their being paid off aside from selling the asset.»

    The reply by Sir Mervyn King does not deny any of that, he replied that it is perfectly natural and balanced, with what I assume was a straight face. A very very funny reply.

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